Getting Long Vega in SPY

It’s time to buy some volatility or Vega in the SPDR Trust (SPY). This is the first time in over 4 months one can say options or implied volatility are inexpensive on a relative basis to the realized or historical volatility. And yes, it is also low on absolute basis, at 12% level, meaning even if it doesn’t lift we’d only be jumping out the ground floor window and mainly bruised by time decay.

I’m going to establishing both bullish and bearish positions in the SPY. Remember volatility does not not have a directional bias, it merely measures the magnitude of a move. But given that the fear tends to be driven the downside I’m going to use two different approaches that account for likelihood that implied volatility (let’s call it the VIX) will stay low on continuation of the rally, but would jump on a market decline.

Before getting to the specific positions a quick rundown of how and why I believe option are cheap and merit a buy at this point.

- During the month of August when the market went dead, but anxiety remained high as a series of events loomed; Jackson Hole, monthly jobs report, German vote to decide on approving ECB’s ability to buy sovereign debt, FOMC meeting options, kept the implied volatility on SPY and the VIX around the 16% level even as the 30 day HV sank below 10%. That was a 6 point or nearly 60% premium. This “fear” extended out into the future as the term structure of VIX futures had a steep contango. The November contracts were trading at 25 and December was 27. These were also 60% premiums, an extreme skew that would need to be resolved.

- Now that we have passed through these events IV and HV are reverting to their mean. As they should give these are statistical measures, not an asset class as many have come to believe. With the market rally following Ben’s bazooka the 30 day HV has actually risen to 12.5% while the IV on SPY has dropped down to 13% level. The VIX and its term structure has also flattened out with front month now trading 14 or just 7% premium and the November futures are now trading 17.50 or 25% premium to the front month. This convergence of prices suggests options are now relatively inexpensive.

- Many of the issues that inflated IV during August remain in place and will come back into play in coming weeks. The fiscal cliff, the uncertainty of the U.S. election, the lack of any real resolution or solution for the EuroDrone, geo-political unrest on the rise and finally we will be entering earning seasons which ticks up volatility even in the best of circumstances.